How a legally binding contract is formed

A contract is a promise or agreement made voluntarily between two or more parties.

A contract is legally enforceable only if:

• agreement has been reached between the parties;
• consideration has been given by at least one of the parties;
• the parties have legal capacity and intend the contract to be legally binding; and
• formalities are complied with.

Agreement between parties

Agreement is reached when a party (the offeror) makes an offer and the other party (the offeree) accepts that offer.

Offer

An offer is a promise to perform an act if the other party promises to do something in return. An offer is distinguishable from an ‘invitation to deal’, which is a request for an offer from a party. For example, the request for a tender is generally regarded as an invitation to deal and the tender itself will be treated as an offer. However, if the party seeking the tender binds itself to accept the highest bid, this may be treated as an offer to do so.

Requests for information and statements of the possible terms are not offers. Therefore, if a party provides the requested information, it will not give rise to a contract between the parties.

An offer will expire if it is revoked, it is not accepted on time, a requirement of the offer is not met (a condition precedent), it is rejected, or a counter-offer is made. A counter-offer is an offer made in response to the initial offer. For example, where a party agrees to enter into a contract, but on terms different to those initially offered, then it is a rejection of the first offer and amounts to a counter-offer. The counter-offer must be accepted by the initial offeror before a contract can be formed.

Acceptance

An offer can be accepted by words or conduct, provided the words or conduct occur in response to the offer and correspond exactly with the terms of the offer. Therefore, an offer may be accepted where business is transacted over a period of time in accordance with the terms of an offer, even if the offer was never accepted in writing or by express words. However, if a party is unaware of an offer, the words or conduct will not be an acceptance of the offer.

Agreement between parties does not require discussion and assent of every term of the contract. If a party accepts the offered terms, then that party will have accepted all of the terms regardless of whether they have read or understood each of the individual terms. There will be acceptance regardless of the actual intention of the parties.

The agreement is generally concluded at the time and place that the acceptance is received by the offeror.

Battle of the forms

Where parties exchange inconsistent standard form contracts during contract negotiations and reach agreement on the principal terms without deciding whose standard form should prevail, a ‘battle of the forms’ may result. The courts have held that the last form sent prevails, provided the recipient has accepted its terms, as each new form is viewed as a counter-offer that destroys the previous offer (Butler Machine Tool Co Ltd v Ex-Cell-O Corp (England) Ltd [1979] 1 WLR 401).

Certainty

An agreement may not be legally binding if its terms are too ambiguous to be enforced, vital terms are incomplete or terms refer to future matters that are to be agreed (‘agreements to agree’, see intention and heads of agreement in this chapter). The courts will attempt to resolve uncertainty by using extrinsic evidence, trade custom, standards of reasonableness, or by severing the uncertain part of the agreement from the remainder.

Consideration

Consideration is an act by the offeree in exchange for the performance or non-performance of an act promised by the offeror. Consideration is commonly the payment of money, but can be a right, interest, profit or benefit accruing to the offeror. The offeree must undertake or suffer detriment.

The value of the consideration does not need to be adequate compensation for the promise, but it must be sufficient; ie there must be an actual detriment. There will not be consideration where a party undertakes to perform an act, but has the right not to do so or is exempt from liability if the act is not performed. Therefore, an exemption clause that excludes a party’s liability for breach of contract may not be consideration and may prevent a contract from being formed. Similarly, there may not be consideration where the price is to be fixed unilaterally by the offeree.

If no consideration is given for a promise, the promise is regarded as a gift and is unenforceable. Acts performed before a promise is given, or performed independently of the promise, are not consideration as they are not undertaken in exchange for the promise. Therefore, condition precedents are not consideration.

Consideration is not required for the enforcement of a deed or if promissory estoppel applies, which is discussed in Chapter 1 – The effect of promissory estoppel.

Capacity

Bankruptcy, incorporation and an entity’s status as a government entity may affect a party’s capacity to make a legally binding agreement.

Companies have the legal capacity to make, vary or discharge a contract by executing the document in accordance with the requirements of the Corporations Act 2001 (Cth). Pre-incorporation contracts made by a ‘promoter’ may be ratified by the company upon incorporation. However, if the company does not ratify the contract, or does not honour its contractual obligations, the promoter may be personally liable. Unincorporated associations do not have contractual capacity. Therefore, contracts can only be made with the individual members of the association or with the management committee members.

Bankrupt parties can enter into contracts. However, contracts made with a bankrupt party face the risk of not being performed, or not obtaining settlement where judgment is made against the bankrupt party and the trustee has not approved the contract. Contracts made before bankruptcy may be disclaimed by the leave of the court or by the trustee if the contract is unprofitable.

Statutory limitations may restrict the contractual capacity of government authorities and agencies, in some cases making a contract invalid.

Intention

There is a presumption that parties to commercial agreements intend them to be legally binding. This can be rebutted if the agreement contains an ‘honour clause’. That is, a clause stating that the agreement is not entered into as a formal or legal agreement and is not subject to any legal jurisdiction. Representations of a party’s intentions, where these statements do not contain promises, may also fail to be legally binding. A court will consider the parties’ words and conduct in their total factual context.

Agreements that have been held to be not legally binding include agreements reached during preliminary negotiations (‘agreements to agree’ in Masters v Cameron (1954) 91 CLR 353), a government subsidy scheme (Australian Woollen Mills Pty v Commonwealth (1954) 92 CLR 424), and trade union and employer agreements (Ford Motor Co Ltd v Amalgamated Union of Engineering & Foundry Workers [1969] 2 All ER 481).

Formalities

Provided all of the above preconditions are met and subject to statutory exceptions, a contract can be formed orally, in writing, by conduct, or by a mixture of these means. Statutory exceptions include contracts relating to interests in land and contracts of guarantee, which must be in writing and signed by the party against whom proceedings are being brought.

The contract terms

A contract may include terms expressly agreed between the parties and implied terms. Express terms may be written, oral or a combination of the two and may be evidenced by one or several documents and conversations. Statements made during pre-contractual negotiations may be considered a term of the contract, a collateral contract, a representation or merely a sales puff.

Generally, where a written contract exists:

• signatories to the contract are bound by the terms of the contract; and
• no extrinsic evidence can be given to show that the terms are different from the terms in the written contract (the parol evidence rule).

Exceptions to the parol evidence rule include where there is fraud, misrepresentation, mistake, duress, no intention to be contractually bound, non-fulfilment of a condition precedent or consideration, variation or discharge of the contract, or ambiguous or incomplete terms.

Rather than focus on the restriction posed by the parol evidence rule, the courts increasingly focus on an objective determination of the meaning of the contract.

Once the terms of the contract have been determined, their meaning must be determined objectively. The construction of the contract must be determined by what a reasonable person in the position of a party to the contract would have understood them to mean. That requires consideration, not only of the text of the documents, but also the surrounding circumstances known to the parties, and the purpose and object of the transaction (Pacific Carriers Ltd v BNP Paribas (2004) 218 CLR 415 at [22]).

Terms may be implied into a contract where required by law (eg the Australian Consumer Law 2010 (Cth)), to give effect to what the parties intended at the time of the contract, by trade custom, or by the conduct of the parties.